Low interest and the "Cash" myth...

For those prepared to take on extra risk, exiting cash may make sense. But for the nearly or already retired, capital preservation is key. For many SMSF trustees, cash remains the preferred defensive asset. Rising competition among banks for consumer deposits means returns are still ahead of the most defensive asset – government bonds.

One of the more strange "finance profession" comments I have recently heard, is "Stay in Cash, you will slowly Fry. PMSL"1
- David Lunn, Director , LifeStyle Wealth Partners.

Fear uncertainty and doubt (FUD), combined with economic jargon slips many trustees into a comatose like state, and rightly so: finance professionals carve out a living making simple subjects seem complex. It’s the best way to convince you to part with your hard-earned money.  Throw away comments like the above, typically have a tendency to be very light on any facts, and often emotive, or personal in focus.

Inflation
So why do we care about inflation? Because it is meant to give us an indication of how the prices we pay for goods and services vary over time. Inflation is one measure of the cost of living. Hence, inflation suddenly becomes important to all savers. We need the savings we set aside for retirement to beat inflation. If we don’t, our nest egg will not keep pace with our lifestyle. And if we’re in retirement, we want our savings to generate returns that, as a minimum, meet or exceed inflation otherwise our purchasing power will shrink.

Since 1982, annual “core” or “underlying” inflation in Australia has averaged about 4 per cent. If we focus only on the period since 1993 when the Reserve Bank of Australia formally started targeting the inflation rate with its chief policy instrument, known as the “target cash rate”, inflation has averaged a touch under 3 per cent.

Hence an overall savings strategy should deliver returns greater than 3 per cent annually with the minimum possible risk.

A related issue is what sectors offer savers effective “inflation hedges”. In this context, there is a pervasive myth that fixed income is a bad inflation hedge. This is both right and wrong. Fixed-rate bonds that pay a set rate of income decline in value in periods when inflation is high and interest rates rise.
This is not hard to understand: if you buy a bond that returns 5 per cent annually for six years and interest rates on other bonds rise to 6 per cent, your bond’s price will fall until its yield makes investors indifferent between the two alternatives.

RBA cash rate and Inflation
This begs the question of whether the RBA’s target cash rate is a good inflation hedge?

The chart below shows the correlation between the RBA’s cash rate and core inflation since 1990. Given the RBA is officially mandated to manage inflation with its policy rate, one finds, the correlation between interest rates and inflation is a strong at around 73 per cent.

The Cash Myth?

Contrary to popular myth, cash is, therefore, an excellent inflation hedge.

But does it give you a “real” return above your cost of living?

If one received, say, 1 per cent annually above the RBA’s cash rate through smart investments in bank deposits, your “real” return after inflation would have averaged about 4 per cent over this period. 

An alternative Strategy

"If the objective is to produce a steady, tax-effective income stream, good quality shares with a long history of paying dividends are a real alternative to a term deposit.
Some current yields are very attractive and if you then add the franking credit, you are looking at a nice, tidy return,” he says.
He adds this strategy requires investors to be comfortable with short-term volatility as their capital will still vary. But by focusing on quality and targeting companies with high dividends, investors may also experience less volatility as typically many are defensive stocks".
- John Donald , Partner and Senior adviser , Ipac Western Australia

Peak Debt and the Effectiveness Monetary Policy

So why has monetary policy become ineffective?
The answer is deceptively simple.
Loose monetary policy is designed to encourage consumption and investment by making current period consumption and riskier assets more attractive, and has historically been an effective tool in this regard.
This is no longer the case because we have collectively reached ‘peak debt’ (at least in most western countries, including Australia).

Whether an individual, organisation or nation state, for any given level of income there is a maximum level of debt that can be accumulated without triggering a repricing of risk. Beyond ‘peak debt’ any further increase leads to a repricing of credit risk – the price that must be paid for that debt.

If you can’t increase income, you can’t increase the debt level. The monetary authorities are trying to send one signal about the pricing of credit, but at a national level the markets are sending exactly the opposite signal – the two just cancel each other out. (There is some increase in consumption because of the cash savings in interest cost, but at a national level this tends to be neutralised because one person’s interest expense is another person’s income).

This is the fundamental cause of Europe’s woes – countries like Greece, Spain and Portugal went past their ‘peak debt’ levels, and their creditors started to re-price their debt because doubts emerged about their credit-worthiness.

The RBA will continue to cut interest rates, but their efforts will be in vain, because many economists, suggest that we have already borrowed as much as we can for our current level of income, given the mining boom is over(and having spent much of the money on non-productive real estate assets, have little in the way of options for driving the improvements in productivity which are a fundamental pre-requisite for increasing the size of the Aussie pie).

Risk

The GFC is still fresh in many people’s minds of many and there are still concerns over the state of the European and US economies, so there is still a comfort factor in bank accounts and term deposits, even if returns may be lower, than some alternatives.

This article looks at cash with a view, that cash, correctly managed, can provide a reasonable return, plus an inflation hedge, with very low risk.

But as always, it is up to the individual SMSF trustee, to get the facts and make an informed decision.

“I can afford to be patient, but to make an acceptable return above inflation, I need to take some risk. Diversification is important because nobody can accurately forecast the future value of any investment.”
- David Murray, Senior Adviser, Credit Suisse

Notes

1. PMSL, is slang for Pissing MySelf Laughing..

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